SHORT ANSWER QUESTIONS, EXERCISES, AND PROBLEMS

Questions

➢  What are the advantages of obtaining long-term funds by the issuance of bonds rather than additional shares of capital stock? What are the disadvantages?

➢  What is a bond indenture? What parties are usually associated with it? Explain why.

➢  Explain what is meant by the terms coupon, callable, convertible, and debenture.

➢  What is meant by the term trading on the equity?

➢  When bonds are issued between interest dates, why should the issuing corporation receive cash equal to the amount of accrued interest (accrued since the preceding interest date) in addition to the issue price of the bonds?

➢  Why might it be more accurate to describe a sinking fund as a bond redemption fund?

➢  Indicate how each of the following items should be classified in a balance sheet.

• Cash balance in a sinking fund.
• Accrued interest on bonds payable.
• Debenture bonds payable due in 2019.
• Premium on bonds payable.
• First-mortgage bonds payable, due 2010 July 1.
• Discount on bonds payable.
• First National Bank—Interest account.
• Convertible bonds payable due in 2012.

➢  Why is the effective interest rate method of computing periodic interest expense considered theoretically preferable to the straight-line method?

➢  Why would an investor whose intent is to hold bonds to maturity pay more for the bonds than their face value?

➢  Of what use is the times interest earned ratio?

Exercises

Exercise A On 2010 September 30, Domingo’s Construction Company issued $ 120,000 face value of 12 per cent, 10-year bonds dated 2010 August 31, at 100, plus accrued interest. Interest is paid semiannually on February 28 and August 31. Domingo’s accounting year ends on December 31. Prepare journal entries to record the issuance of these bonds, the accrual of interest at year-end, and the payment of the first interest coupon.

Exercise B On 2009 December 31, East Lansing Office Equipment Company issued $ 1,600,000 face value of 8 per cent, 10-year bonds for cash of $ 1,400,605, a price to yield 10 per cent. The bonds pay interest semiannually and mature on 2019 December 31.

1. State which is higher, the market rate of interest or the contract rate.
2. Compute the bond interest expense for the first six months of 2010, using the interest method.
3. Show how the $ 1,400,605 price must have been determined.

Exercise C Compute the annual interest expense on the bonds in the previous exercise, assuming the bond discount is amortized using the straight-line method.

Exercise D After recording the payment of the interest coupon due on 2010 June 30, the accounts of Myrtle Beach Sailboat, Inc., showed Bonds Payable of $ 300,000 and Premium on Bonds Payable of $ 10,572. Interest is payable semiannually on June 30 and December 31. The five-year, 12 per cent bonds have a face value of $ 300,000 and were originally issued to yield 10 per cent. Prepare the journal entry to record the payment of interest on 2010 December 31. Use the interest method. (Round all amounts to the nearest dollar.)

Exercise E On 2010 June 30 (a semiannual interest payment date), Holiday Rollerblade Company redeemed all of its $ 400,000 face value of 10 per cent bonds outstanding by calling them at 106. The bonds were originally issued on 2006 June 30, at 100. Prepare the journal entry to record the payment of the interest and the redemption of the bonds on 2010 June 30.

Exercise F On 2009 August 31, as part of the provisions of its bond indenture, Caribbean Cruise Line, Inc., acquired $ 480,000 of its outstanding bonds on the open market at 96 plus accrued interest. These bonds were originally issued at face value and carry a 12 per cent interest rate, payable semiannually. The bonds are dated 2002 November 30, and pay semiannual interest on May 31 and November 30. Prepare the journal entries required to record the accrual of the interest to the acquisition date on the bonds acquired and the acquisition of the bonds.

Exercise G Cleveland Heating Systems, Inc., is required to make a deposit of $ 18,000 plus semiannual interest expense of $ 540 on 2009 October 31, to the trustee of its sinking fund so that the trustee can redeem $ 18,000 of the company’s bonds on that date. The bonds were issued at 100. Prepare the journal entries required on October 31 to record the sinking fund deposit, the bond retirement, payment of interest (due on that date), and payment of trustee expenses, assuming the latter is $ 100.

Exercise H After interest was paid on 2010 September 30, $ 60,000 face value of Miami Video Rentals, Inc., outstanding bonds were converted into 8,000 shares of the company’s $ 5 par value common stock. Prepare the journal entry to record the conversion, assuming the bonds were issued at 100.

Exercise I A recent annual report of Wal-Mart Corporation showed the following amounts as of the dates indicated:

	Year	Ended	January 31
	2001	2000	1999
Earnings before interest (and taxes)(millions)	$11,583	$10,162	$8,008
Interest expense (millions)	1,467	1,079	838

Calculate the times interest earned ratio for each year and comment on the results.

Exercise J What is the present value of a lump-sum payment of $ 20,000 due in five years if the market rate of interest is 10 per cent per year (compounded annually) and the present value of $ 1 due in five periods at 10 per cent is 0.62092?

Exercise K What is the present value of a series of semiannual payments of $ 10,000 due at the end of each six months for the next five years if the market rate of interest is 10 per cent per year and the present value of an annuity of $ 1 for 10 periods at 5 per cent is 7.72173?

Exercise L Joe Mordino bought a ticket in the Georgia lottery for $ 1, hoping to strike it rich. To his amazement, he won $ 4,000,000. Payment was to be received in equal amounts at the end of each of the next 20 years. Mordino heard from relatives and friends he had not heard from in years. They all wanted to renew their relationship with this new millionaire. Federal and state income taxes were going to be about 40 per cent (36 per cent for federal and 4 per cent for state) on each year’s income from the lottery check. The discount rate to use in all present value calculations is 12 per cent.

1. How much will Mordino actually receive after taxes each year?
2. Is Mordino a multimillionaire according to the present value of his cash inflow after taxes?
3. What is the present value of the net amount the state has to pay out? Remember that the state gets part of the money back in the form of taxes.

Exercise M After Joe Mordino won $ 4,000,000 in the Georgia lottery, he decided to purchase $ 10,000 of lottery tickets at the end of each year for the next 20 years. He was hoping to hit the lottery again, but he never did. If the state can earn 12 per cent on ticket revenue received, how much will the annuity of $ 10,000 from Mordino grow to by the end of 20 years?

Problems

Problem A On 2009 June 1, Economy Auto Parts, Inc., issued $ 180,000 of 10-year, 16 per cent bonds dated 2009 April 1, at 100. Interest on bonds is payable semiannually on presentation of the appropriate coupon. All of the bonds are of $ 1,000 denomination. The company’s accounting period ends on June 30, with semiannual statements prepared on December 31 and June 30. The interest payment dates are April 1 and October 1.

All of the first coupons on the bonds are presented to the company’s bank and paid on 2009 October 2. All but two of the second coupons are similarly received and paid on 2010 April 1.

Prepare all necessary journal entries for these transactions through 2010 April 1, including the adjusting entry needed at 2009 June 30.

Problem B Ecological Water Filtration, Inc., is going to issue $ 400,000 face value of 10 per cent, 15-year bonds. The bonds are dated 2009 June 30, call for semiannual interest payments, and mature on 2024 June 30.

1. Compute the price investors should offer if they seek a yield of 8 per cent on these bonds. Also, compute the first six months’ interest, assuming the bonds are issued at this price. Use the interest method and calculate all amounts to the nearest dollar.
2. Repeat part (a), assuming investors seek a yield of 12 per cent.

Problem C On 2009 July 1, South Carolina Table Company issued $ 600,000 face value of 10 per cent, 10-year bonds. The bonds call for semiannual interest payments and mature on 2019 July 1. The company received cash of $ 531,180, a price that yields 12 per cent.

Assume that the company’s fiscal year ends on March 31. Prepare journal entries (to the nearest dollar) to record the bond interest expense on 2010 January 1, and the adjustment needed on 2010 March 31, using the interest method. Calculate all amounts to the nearest dollar.

Problem D Storall Company issued $ 200,000 face value of 16 per cent, 20-year junk bonds on 2010 July 1. The bonds are dated 2010 July 1, call for semiannual interest payments on July 1 and January 1, and were issued to yield 12 per cent (6 per cent per period).

1. Compute the amount received for the bonds.
2. Prepare an amortization schedule similar to that in Exhibit 5. Enter data in the schedule for only the first two interest periods. Use the interest method.
3. Prepare journal entries to record issuance of the bonds, the first six months’ interest expense on the bonds, and the adjustment needed on 2011 May 31, assuming the company’s fiscal year ends on that date.

Problem E Kelly Furniture Company issued $ 400,000 face value of 18 per cent, 20-year junk bonds on 2009 October 1. The bonds are dated 2009 October 1, call for semiannual interest payments on April 1 and October 1, and are issued to yield 16 per cent (8 per cent per period).

1. Compute the amount received for the bonds.
2. Prepare an amortization schedule similar to that in Exhibit 5. Enter data in the schedule for only the first two interest periods. Use the interest method and make all calculations to the nearest dollar.
3. Prepare entries to record the issuance of the bonds, the first six months’ interest on the bonds, and the adjustment needed on 2010 June 30, assuming the company’s fiscal year ends on that date.

Problem F Houston Clothing Company issued $ 600,000 of 12 per cent serial bonds on 2009 July 1, at face value. The bonds are dated 2009 July 1; call for semiannual interest payments on July 1 and January 1; and mature at the rate of $ 120,000 per year, with the first maturity date falling on 2010 July 1. The company’s accounting period ends on September 30.

Prepare journal entries to record the interest payment of 2010 July 1; the maturing of $ 120,000 of bonds on 2010 July 1; and the adjusting entry needed on 2010 September 30. Also, show how the bonds would be presented in the company’s balance sheet for 2010 September 30.

Alternate problems

Alternate problem A On 2009 December 1, New Jersey Waste Management Company issued $ 300,000 of 10-year, 9 per cent bonds dated 2009 July 1, at 100. Interest on the bonds is payable semiannually on July 1 and January 1. All of the bonds are registered. The company’s accounting period ends on March 31. Quarterly financial statements are prepared.

The company deposits a sum of money sufficient to pay the semiannual interest on the bonds in a special checking account in First National Bank and draws interest payment checks on this account. The deposit is made the day before the checks are drawn.

Prepare journal entries to record the issuance of the bonds; the December 31 adjusting entry; the 2010 January 1, interest payment; and the adjusting entry needed on 2010 March 31, to prepare quarterly financial statements.

Alternate problem B Safe Toy Company is seeking to issue $ 800,000 face value of 10 per cent, 20-year bonds. The bonds are dated 2009 June 30, call for semiannual interest payments, and mature on 2029 June 30.

1. Compute the price investors should offer if they seek a yield of 8 per cent on these bonds. Also, compute the first six months’ interest assuming the bonds are issued at that price. Use the interest method and calculate all amounts to the nearest dollar.
2. Repeat part (a) assuming investors seek a yield of 12 per cent.

Alternate problem C On 2009 July 1, Tick-Tock Clock Company issued $ 100,000 face value of 8 per cent, 10-year bonds. These bonds call for semiannual interest payments and mature on 2019 July 1. The company received cash of $ 87,538, a price that yields 10 per cent.

Assume that the company’s fiscal year ends on March 31. Prepare journal entries to record the bond interest expense on 2010 January 1, and the adjustment needed on 2010 March 31, using the interest method. Calculate all amounts to the nearest dollar.

Alternate problem D Creative Web Page issued $ 600,000 face value of 15 per cent, 20-year bonds on 2010 October 1. The bonds are dated 2010 October 1, call for semiannual interest payments on April 1 and October 1, and are issued to yield 16 per cent (8 per cent per period).

1. Compute the amount received for the bonds.
2. Prepare an amortization schedule similar to that in Exhibit 4. Enter data in the schedule for only the first two interest periods. Use the interest method.
3. Prepare journal entries to record issuance of the bonds, the first six months’ interest expense on the bonds, and the adjustment needed on 2011 May 31, assuming Creative Web Page’s fiscal year ends on that date.

Alternate problem E Goodhew Software Systems, Inc., issued $ 100,000 face value of 10 per cent, 20-year bonds on 2009 July 1. The bonds are dated 2009 July 1, call for semiannual interest payments on July 1 and January 1, and are issued to yield 12 per cent (6 per cent per period).

1. Compute the amount received for the bonds.
2. Prepare an amortization schedule similar to that in Exhibit 4. Enter data in the schedule for only the first two interest periods. Use the interest method and calculate all amounts to the nearest dollar.
3. Prepare entries to record the issuance of the bonds, the first six months’ interest on the bonds, and the adjustment needed on 2010 June 30, assuming Goodhew’s fiscal year ends on that date.

Alternate problem F Western Solar Energy Company issued $ 400,000 of 12 per cent bonds on 2009 July 1, at face value. The bonds are dated 2009 July 1, call for semiannual payments on July 1 and January 1, and mature at the rate of $ 40,000 per year on July 1, beginning in 2010. The company’s accounting period ends on September 30.

1. Prepare journal entries to record the interest expense and payment for the six months ending 2010 July 1; the maturing of the bonds on 2010 July 1; and the adjusting entries needed on 2010 September 30.
2. Show how the bonds would be presented in the company’s balance sheet for 2010 September 30.

Beyond the numbers—Critical thinking

Business decision case A A company is trying to decide whether to invest $ 2 million on plant expansion and $ 1 million to finance a related increase in inventories and accounts receivable. The $ 3 million expansion is expected to increase business volume substantially. Profit forecasts indicate that income from operations will rise from $ 1.6 million to $ 2.4 million. The income tax rate will be about 40 per cent. Net income last year was $ 918,000. Interest expense on debt now outstanding is $ 70,000 per year. There are 200,000 shares of common stock currently outstanding. The $ 3 million needed can be obtained in two alternative ways:

• Finance entirely by issuing additional shares of common stock at an expected issue price of $ 75 per share.
• Finance two-thirds with bonds, one-third with additional stock. The bonds would have a 20-year life, bear interest at 10 per cent, and sell at face value. The issue price of the stock would be $ 80 per share.

Should the investment be made? If so, explain which financing plan you would recommend. (Hint: Calculate earnings per share for last year and for future years under each of the alternatives.)

Business decision case B An annual report of a company contained the following paragraph in the notes to the financial statements:

The 9 7/8 per cent Senior Subordinated Debentures are redeemable at the option of [the company] at 103.635 per cent of the principal amount plus accrued interest if redeemed prior to [a certain date], and at decreasing prices thereafter. Mandatory sinking fund payments of $ 3,000,000 (which [the company] may increase to $ 6,000,000 annually)…and are intended to retire, at par plus accrued interest, 75 per cent of the issue prior to maturity.

Answer the following questions:

1. What does the term debentures mean?
2. How much is the call premium initially? Does this premium decrease over time?
3. Under what circumstances might the company want to increase the sinking fund payments?

Business decision case C The Wall Street Journal contained a table showing yield comparisons for groups of corporate bonds. The following data have been adapted from the table:

		Yield	Percentage
		As of	52-week
	4/28	4/27	High	Low
Risk category
1-10 year maturities:
High quality	7.08%	6.94%	7.16%	5.32%
Medium quality	7.41	7.26	7.49	5.76
Over 10 year maturities:
High quality	7.91	7.81	8.06	6.93
Medium quality	8.36	8.25	8.49	7.29
High-yield bonds	10.45	10.48	10.53	9.25

Standard & Poor’s ratings were:
High quality	AAA to AA
Medium quality	A to BBB
High yield	BB to C

Prepare written answers to the following questions.

1. In each column of numbers, why do the yield rates increase from top to bottom?
2. For the high quality and medium quality bonds, what could account for the increase in the yield rates from 4/27 to 4/28? Take into consideration possible economic events.
3. Which risk class of bonds was closest to its 52-week high on 4/28? What could have been the cause?

Annual report analysis D Refer to the Annual report appendix and determine the times interest earned ratio for 2003 for The Limited. Use “operating income” to represent IBIT. Prepare written comments on the results of your analysis.

Annual report analysis E A recent annual report of Emhart Corporation contained the following paragraph in its notes to the financial statements:

The 6 3/4 per cent convertible subordinated debentures may be converted into shares of common stock at a price of $ 26.50 per share at any time prior to maturity. They are redeemable at prices decreasing from 105 per cent of face amount currently to 100 per cent [at a certain future date].

Answer the following questions:

1. If you held one $ 1,000 bond, how many shares of stock would you receive if you converted the bond into shares of stock? (Hint: You can use the principal amount of the bond to buy shares of stock at the stated price.)
2. Assume you held one $ 1,000 bond and the bond was called by the company at a price of 105 per cent of the face amount. If the current market price per share of the stock was $ 29, would you convert the bond into shares of stock or would you surrender the bond? Explain.

Ethics case – Writing experience F Refer to “An ethical perspective: Rawlings furniture company”. Write out the answers to the following questions:

1. What motivates the brothers to pursue this new strategy?
2. Are the brothers the only ones assuming the risks?
3. How will workers, the city, the holders of the original bond issue, and the other present stockholders be affected if the junk bonds are issued and are then defaulted?
4. How might these parties (stakeholders) be affected if a new buyer outbids the management?
5. What ethical considerations are involved?

Group project G In groups of two or three students, write a two-page, double-spaced paper on one of the following topics:

The Use of Junk Bonds in the 1980s

Why Market Rates of Interest and Prices of Bonds Are Inversely Related

How a Company Can Force Conversion of Callable, Convertible Bonds

How Bond Sinking Funds Work

Do some library research on your topic and properly cite your sources. Make your analysis convincing. Your paper should be neat, contain no spelling or grammatical errors, and be the result of several drafts. Use a word processing program to prepare your paper if possible. Your paper should have a cover page with the title and the authors’ names.

Group project H In a small group of students, locate Accounting Principles Board Opinion No. 21 (from a faculty member or from the library) relating to the amortization of premiums and discounts on bonds. Investigate why the Board recommended the effective interest rate method over the straight-line method for amortizing bond premiums and discounts. Which method do you favor and why? Summarize the highlights of the APB Opinion and your own opinions in a written report to your instructor.

Group project I With one or two other students, locate the annual reports of three companies with bonds outstanding as part of their long-term debt. You should read the notes to the financial statements to determine the composition of the long-term debt. Identify the bonds (e.g. debentures, serial), their interest rates, and any other information pertaining to them. Compare the bonds outstanding for the three companies. Write a report to your instructor summarizing your findings.

Using the Internet—A view of the real world

Visit the following site for the Eastman Kodak Company:

http://www.kodak.com

By following the instructions on the screen, locate the notes to the financial statements and find the one pertaining to long-term debt. In your own words, write a short report to your instructor summarizing the types of long-term debt held by the company and some of the details of the arrangements with lenders.

Visit the following website for Eastman Chemical Company:

http://www.eastman.com

Pursue choices on the screen until you locate the financial information. Then investigate long-term borrowings. You will probably go down some “false paths” to get to this financial information, but you can get there. This experience is all part of learning to use the Internet. Check to determine the composition of the long-term borrowings. Check out the notes to the financial statements for further information. Browse around the site for any other interesting information concerning the company. Write a memo to your instructor summarizing your findings.